The Great HFT Debate Is Yesterday's News

If you are still slogging it out over HFT, you are missing the point. The real debate is about market structure.

I'm pretty tired of hearing about HFT. It's like a Sunday morning talk show. We know the Democrats and Republicans never see eye to eye. That's why I don't watch the Sunday morning news programs. They're too predictable.

The same thing is true when it comes to high frequency trading. The debate is predictable and boring. Proponents claim HFT provides lower trading costs and liquidity to investors. The anti-HFT crowd points to electronic front running, mini flash crashes, complex fee structures and other market structure problems that are caused by HFT. We've heard it all before. The two will never see eye to eye. Each side will trot out market data and "studies" that supports their argument.

In short, the current debate surrounding Michael Lewis' "Flash Boys" and his media blitz to promote his book has nothing to do with HFT. It really has to do with an incomprehensible market structure that has developed post Reg NMS. Thirteen exchanges, 40+ dark pools and maybe 200 brokerage internalizers make it all but impossible to make sense of the markets (even for 'sophisticated' investors). The current U.S. market structure that Lewis claims is rigged is 100% legal and complies with all regulations, but is unnecessarily complex and likely harmful to the markets.

I've waited to weigh in on the "Flash Boys" debate until I finished the book, had some time to reflect on it and also speak to a few people in the industry. Truth be told, I think Flash Boys is poorly written. Lewis is generally a very good storyteller, but I think Flash Boys falls short. Lewis chose to ignore many facts and arguments about current market structure. Why? Was he under a page count limit? The book seems rushed and incomplete. If the "HFT provides liquidity" arguments are hogwash, spend a chapter on it and explain to the readers why. We all ponied up $20 to read the book and we'll sit through another chapter if it helps clarify the debate.

The real meat of the book centers on the problems Brad Katsuyama and his band of unlikely heroes at IEX has found in the marketplace. Truth be told, others have been talking about these marketplace inequalities for a number of years, including Joe Saluzzi and Sal Arnuk at Themis Trading and Eric Hunsader at Nanex. Larry Tabb, founder of Tabb Group, also points out the complexity of the markets in a recent column and argues that the markets are not rigged (as Lewis contends). The market structure is complex ... far too complex ... for investors. Having order types that are designed just to sniff out an investor's intent seems crazy, especially when these order types are also designed to never be filled. Lewis took particular aim at the various order types.

The increased usage of dark pools and internalizers is also a big problem. No one really knows what happens to an order while it is in a dark market. According to Reuters, almost 40 percent of all U.S. stock trades now happen somewhere other than the 13 exchanges, up from around 16 percent a few ago.

As an individual investor, I'm not really concerned with losing a few pennies on the five or so trades I make each year. My orders are pretty small, 100 or 200 or maybe even 300 shares. So, yes, I might be getting scalped for a dollar or two by HFT players, but I'm not going to call for a complete rewrite of regulations over a few bucks. There are plenty of other inequities in the world that I should be spending my time worrying about.

But as someone who has a 401(k) filled with mutual funds, I am concerned. If some of the estimates are to be believed, a large mutual fund provider loses millions a year just because of market complexity. In Flash Boys, the president of a $9 billion hedge fund estimated he was losing $300 million a year because of the current market structure. Fidelity Investments has $1.7 trillion under management in its mutual funds alone. Do the math. That gets me pretty angry. Many of the losses that are absorbed by investors come from the ability for some trading shops too take advantage of latency arbitrage, or order type arbitrage, or other techniques that, to my somewhat educated eye, provide no value to investors. I might be wrong, and if I am, I hope someone can enlighten me as to how these various methods help make the markets more liquid and a better place to raise capital.

In the end, I think Katsuyama summed up why this debate is really about market structure and not HFT. In Flash Boys, Katsuyama says:

This is not their fault. I think most of them have just rationalized that the market is creating the inefficiencies and they are just capitalizing on them. Really, it’s brilliant what they have done within the bounds of the regulation. They are much less of a villain than I thought. The system has let down the investor.”

One would hope that a large brokerage house would look at its leakage due to market complexity and fight on behalf of its customers to not lose their money to it. But on the other hand, they might be insulated from the costs.

I think the Sunday talk shows are less likely to discuss the intricate workings of Reg NMS and complex order types. One has to watch the more specific financial markets media channels. The focus on latency arbitrage is only part of the story. It's important to understand the order types that were created to deal with flaws in Reg NMS and its order protection rule.

I don't think reg NMS was created just to let HFT proliferate. I think HFT was and is an unintended consequence of reg NMS. And yes, Einhorn's comments were rather amusing, coming from someone who supposedly knows so much about markets.

True, but as you said " nothing to do with HFT. It really has to do with an incomprehensible market structure"....

Market Structure and HFT are one and the same thing. Market Structure was purposely created to allow HFT to bloom. The proliferation of trading the same security at multiple places/prices enables HFT arb. Does this mean you're just re defining the terms in the sunday talk shows whilst claiming to float above the whole issue?

Big mutual funds and other types of long-only funds didn't know in the early years, perhaps 2007-2009, but they caught on several years ago. They have adjusted their trading strategies by slicing their large orders into smaller 'child orders,' which are executed algorithmically via lit and dark pools. Brokers have built algorithms and low-latency infrastructure with colocation to protect their institutional clients from interacting with predatory HFT strategies. They are not fleecing their clients; they are trying to protect them within the market structure.

Capitalism has always been self serving, but I agree, there should be rules governing electronic trading behavior. If Reg NMS is revisited then it will be possible to close some of the loopholes that allow HFT 'quote stuffing' and jumping in front of institutional orders. As for dark pools, many institutions that manage 401ks have chosen to use dark pools to avoid leaking information and interacting with HFT. The reality is that there should be more transparency into what dark pools do, though this may lead to their extinction.

The consistent message is "the market is rigged" but over the past 25 years the market has become increasingly self serving. Customers, individuals and organizations are as some described "muppets". Whatever principals in the past that governed behaviors the market in the past are no longer evident.

HFT, dark pools and other forms of "insider trading" are examples of self serving. No significant changes are on the horizon and if history is a predictor, change will only occur when a significant event resulting is losses or fraud in pension funds such as 401k's occurs. In the meantime, the only "reality" that should be considered is the market is rigged.

According to Lewis in the book, even sophisticated investors (portfolio managers, fund managers) didn't know they were getting taken for a ride. That's pretty crazy that even some of the big funds were getting fleeced by their brokers and they never knew it.